The Reducing Balance Method (also known as the Declining Balance Method) is a depreciation technique that applies a fixed percentage to an asset’s book value each year. Unlike the Straight-Line Method, which spreads depreciation evenly, the Reducing Balance Method results in higher depreciation expenses in the early years and lower expenses as the asset ages. This method is particularly useful for assets that lose value more rapidly in the first few years, such as vehicles, machinery, and technology.
1. Understanding the Reducing Balance Method
Definition
The Reducing Balance Method calculates depreciation as a fixed percentage of the asset’s book value each year. Since the book value decreases annually, the depreciation expense also reduces over time.
Key Features:
- Depreciation is higher in the early years and decreases over time.
- The asset’s book value never fully reaches zero.
- Suitable for assets that lose value quickly, such as electronics and vehicles.
- Depreciation is calculated on the remaining book value (not the original cost).
2. Formula for the Reducing Balance Method
The formula for annual depreciation under this method is:
Depreciation = Book Value at Beginning of Year × Depreciation Rate
- Book Value: The asset’s value at the start of the accounting period.
- Depreciation Rate: The percentage applied to the book value.
3. Example of the Reducing Balance Method
Scenario:
A company purchases a machine for $10,000. The business applies a 20% reducing balance depreciation rate.
Step-by-Step Calculation:
| Year | Book Value at Start ($) | Depreciation (20%) ($) | Accumulated Depreciation ($) | Book Value at End ($) |
|---|---|---|---|---|
| 1 | 10,000 | 2,000 | 2,000 | 8,000 |
| 2 | 8,000 | 1,600 | 3,600 | 6,400 |
| 3 | 6,400 | 1,280 | 4,880 | 5,120 |
| 4 | 5,120 | 1,024 | 5,904 | 4,096 |
| 5 | 4,096 | 819 | 6,723 | 3,277 |
4. Journal Entry for Reducing Balance Depreciation
Each year, the depreciation expense is recorded in the accounts as follows:
Journal Entry:
Debit: Depreciation Expense
Credit: Accumulated Depreciation
Example (Year 1):
Debit: Depreciation Expense $2,000
Credit: Accumulated Depreciation $2,000
5. Differences Between Reducing Balance and Straight-Line Methods
| Aspect | Reducing Balance Method | Straight-Line Method |
|---|---|---|
| Depreciation Amount | Higher in the early years, decreases over time. | Same amount each year. |
| Calculation Basis | Depreciation is calculated on the remaining book value. | Depreciation is calculated on the original cost. |
| Best For | Assets that lose value quickly (e.g., vehicles, electronics). | Assets that wear out evenly (e.g., buildings, office furniture). |
6. Adjusting the Reducing Balance Method for Partial-Year Depreciation
If an asset is purchased partway through a financial year, the first year’s depreciation is prorated.
Example:
A company purchases a vehicle for $30,000 on July 1st. The depreciation rate is 25%.
Annual Depreciation:
$30,000 × 25% = $7,500
Partial-Year Depreciation (6 months):
($7,500 × 6) ÷ 12 = $3,750
Journal Entry:
Debit: Depreciation Expense $3,750
Credit: Accumulated Depreciation $3,750
7. Advantages of the Reducing Balance Method
- More Realistic Expense Allocation: Reflects higher asset usage in early years.
- Tax Benefits: Higher initial depreciation can reduce taxable income.
- Better for Technology and Vehicles: Ideal for assets that lose value quickly.
8. Disadvantages of the Reducing Balance Method
- Complex Calculations: Requires annual recalculations.
- Does Not Fully Depreciate the Asset: The book value never reaches zero.
When to Use the Reducing Balance Method
The Reducing Balance Method is best suited for assets that depreciate rapidly, such as vehicles, computers, and machinery. It provides a more realistic reflection of asset usage over time and offers tax advantages in early years. However, businesses must consider the complexity of calculations and ensure proper financial planning when using this method.